Using Options to Hedge a Portfolio

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Covered Call

Put Purchase

Risk Reversal

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Using Options to Hedge a Portfolio

A few Cabot Options Trader subscribers have asked me about ways to protect gains in their portfolios, so I thought I would write to everyone with a couple of strategies using options to hedge your portfolio.

Because I can't possibly know what you have in your portfolio, I'll base the strategies on the SPDR S&P 500 ETF ( SPY ), which corresponds to the price and yield performance of the S&P 500 Index. 

(Note: You may not be allowed to hedge your mutual fund holdings by trading the SPY. For instance, if you own mutual fund XYZ, your broker may not allow you to sell calls in the SPY because they don't move in exact correlation. But that is a conversation you should have with your brokerage provider.)    

The SPY is trading at 154.50 this morning. For this exercise, I'm going to assume that you own 1,000 shares of SPY, which is currently worth $154,500. 

Here are a couple different strategies you can use to "hedge" your portfolio.

Covered Call

A covered call is a risk-reducing strategy; in this, a call option is written (sold) against an existing stock position on a share-for-share basis. The call is said to be "covered" by the underlying stock, which could be delivered if the call option is exercised. 

This is a great way to create yield in your portfolio, though I will say it does not "hedge" you entirely. If the SPY were to drop dramatically, you would collect the premium taken in, but you would still be long the stock. 

So based on our example, you own 1000 shares of the SPY, and therefore you are able to sell 10 calls against your stock so that you are covered. 

For this theoretical exercise, I will look seven months out, and 3% out of the money.  Based on this criteria, you could sell the September 159 calls for $3.40. If the SPY stays below 159 by September expiration, you would collect $3,400, or a yield of 2.2%. If you do that twice a year, you would collect $6,800, or a yield of 4.4%. 

You can choose any number of months or strikes. For instance, you can sell 5 September 159 calls and 5 December 161 calls. There are seemingly limitless amounts of calls you can sell, in many different combinations.

This is a profit and loss graph of your covered call position:

September

Put Purchase

Once again, assuming you own 1,000 shares of the SPY, the truest hedge would be to buy 10 puts against it. If the SPY were to drop below your puts strike price, you could simply exercise your puts, and you would be out of your entire stock position. The upside to this strategy is that you do not cap the potential profit if the SPY price continues to rise. 

For instance, you could buy 10 of the April 154 puts for $2.40. So if the SPY were to drop below 154, you would exercise your puts, and you would be taken out of your SPY stock position. However, you have to pay $2.40, or $2,400, for this insurance. But with the VIX at historically low levels, this insurance is extremely cheap based on historical prices. 

Again, you can choose any number of strikes and time frames for this strategy. 

This is a profit and loss graph of your put purchase position:

April

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Risk Reversal    

This is a more sophisticated strategy, but is a truer hedge to your portfolio than a covered call. You must be able to trade spreads in order to execute a Risk Reversal. 

In this example, you will be selling a call that is out of the money and buying a put that is out of the money. This is a strategy that will reduce the capital that you have to pay for your hedge, but it limits your upside.

Once again, assuming you own 1,000 shares of the SPY, you could sell the April 159 call for $0.50 and buy the April 154 put for $2.40. In this case, your capital outlay is only $1.90, whereas in the put purchase above, you were paying $2.40. 

So let's break down the various scenarios of this trade. If the SPY were to go below 154, you could exercise your puts and get out of your stock position. On the other hand, if the SPY were to rally above 159, you would be taken out of your stock position by the holder of your short call. If the SPY were to stay between 154 and 159, the position would expire worthless and you would be out the $1.90 that you paid for this position.      

This is a profit and loss graph of your risk reversal position:

April2

Conclusion

You can use any of these strategies against any of your equity or index holdings. If you own a lot of Boeing ( BA ) or General Electric ( GE ) stock for instance, you can hedge your stock positions with these strategies.

If you want to hedge your mutual fund holdings, talk to your brokerage provider to see how you can implement strategies like these. 

Your guide to successful options trading,

Jacob Mintz

Analyst and Editor, Cabot Options Trader



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Stocks

Referenced Stocks: BA , GE , SPY

Cabot Heritage Corporation

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